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it pays to understand
Page 116
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your tax by R. H. Grimsley BCom, FIAC
14. Different tax rules for sole traders and partnerships
THE ADJUSTMENT of business profit for taxation purposes for a sole trader or partnership closely resembles that for a limited company except that there is no directors' remuneration and the proprietor's own drawings are not an allowable expense. There are other minor differences but the really important one comes in the treatment of the adjusted profit. For the sole trader (one man running the business without partners and without the benefit of limited liability) the entire adjusted profit is treated as his personal earned income. A personal assessment is made, adding any other kinds of income to the business profit. deducting earned income relief from the profit and from any other earnings, taking off the various personal reliefs to arrive at the figure on which tax at the standard rate is to be paid.
For a partnership the adjusted profit is treated as the earned income of the partners, divided among them according to their profit-sharing agreement. The actual tax demand will be addressed to the partnership but in effect in the long run it is the partners themselves who pay the tax.
When the business has been established for more than three years, there is a strange pattern by which the profit shown in the annual accounts which end during one tax year are taken as the man's income for the following tax year. For example, if a year's accounts end on September 30 1971 (or June 30 1971 or December 31 1971 or March 31 1972) they set the income of the tax year 1972/73 with income tax payable in two equal instalments on January I 1973 and July 1 1973. This system is called preceding year basis.
It will be seen that this makes quite a long delay between creating the profit and having to pay the tax. Very nice from the taxpayer's point of view and the profit remains at his disposal through all the intervening months until it is needed to pay the tax. Some firms even rely on the next year's profit being made in time to meet the tax demand in this year's profit, but in doing so they run a serious risk. Suppose the next year's profit is much smaller, it will simply not be enough but somehow the money must be found to pay the tax.
This explains why all forward-looking traders take care not to commit their funds too deeply when they know there is this liability for tax coming up at a time when Current profits happen to be lower than usual.
Limited company
There was a time for a few years from 1965 when the limited company was at a disadvantage over tax compared to the sole trader or partnership. but the corporation tax rules have been gradually modified. The position today is that a small business making moderate profits is neither helped nor penalized by the different tax treatment. Although the company is within the corporation tax rules, provided the directors' remuneration is planned carefully, the total tax burden will be neither greater nor smaller than for a sole trader or partnership.
When profits become larger, above about £7000 per year per man, the company begins to have a definite advantage. This is because the large personal income of the partner or sole trader becomes subject to surtax on a steeply sliding scale, while profit retained in the company is taxed only at 40 per cent corporation tax rate.
If one man starts a small haulage business on his own, there is no money to be saved from a tax point of view in creating a limited company, though he would be well advised to do so from the legal aspect.
Where two or more men combine together to form a business, with the choice between forming a company or partnership, legal considerations other than tax lean strongly in favour of the company. As with the one-man business, tax is fairly indifferent until profits become substantial when the company has the advantage. The legal points exist right from the beginning although they usually do not look important until a later date by which time it is too late to go back and restructure the organization.
It is a fairly complicated matter to switch from partnership to company and virtually impossible when some weakness has already started to cause trouble. So it is better to begin with a company right from the start. There is rather more expense in forming the company than a partnership and just a little more annual cost in keeping it in line with the requirements of the Companies Acts, but the small extra outlay is fully justified by the way the company avoids major long-term problems which hit many partnerships. Partnerships are satisfactory enough while everything runs smoothly but their weakness is obvious when profits are low or funds are short or one of the partners quits. retires or dies.
This is not intended as an exhaustive comparison between partnership and companies. but really to stress the fact that tax is almost neutral in the choice, while the legal points encourage the use of a company.